Many individuals give careful consideration during the estate planning process to the taxes their loved ones will have to pay after they die.
The current estate tax exemption is at the record-high level of $12.06 million for individuals and $24.12 for couples. Fewer people than ever have to worry about estate taxes. However, the law that created those exemption levels is set to expire in 2025. The estate tax exemption would drop down to $5 million, which would make estate taxes a reality for many more families. President Biden has even indicated that he would like to reduce the exemption amount to $3.5 million.
Irrevocable life insurance trusts are one of the tools estate planning attorneys can use to reduce the potential estate tax burden on your family. They’re more complex than your average living trust, though. Understanding how they work and what’s required to maintain them is important before you dive into creating one with your attorney.
What is an irrevocable life insurance trust?
An irrevocable life insurance trust (ILIT, pronounced “eye-lit”) is a special type of trust created to control a life insurance policy — either term or permanent — while the insured is still alive. ILITs are most commonly used for tax avoidance. But they have many of the other benefits associated with trusts, including probate avoidance, legacy planning, and control over the distribution of assets.
ILITs can own traditional individual life insurance policies as well as second-to-die policies. These are policies that insure two people (generally a married couple) but only pay a death benefit when the second person dies.
As with any trust, an ILIT has a grantor, a trustee, and a beneficiary (or multiple beneficiaries). However, ILITs are irrevocable. That means they cannot be changed or dissolved once they are created. Unlike in the case of the commonly used revocable trust, the grantor does not remain in control of the assets (here, a life insurance policy) placed into the ILIT.
The trustee has sole control. They make any necessary updates to the policy and pay all premiums for the life insurance policy from the trust.
Because the trustee must pay the premiums (avoiding any indication that you’re actually the owner of the life insurance policy), it’s imperative that you adequately fund the trust and provide a mechanism for paying the premiums..
The ILIT is the beneficiary of life insurance policy, so it receives the death benefits when the insured dies. The ILIT trustee then distributes those proceeds according to the terms of the trust.
See: Estate Planning for High Net Worth Individuals
What are the benefits of creating an ILIT?
ILITs have many similar benefits to other types of trusts, including that they keep assets out of probate. Here are two others that are particularly important in the case of ILITs.
Estate tax avoidance or minimization
Under normal circumstances, the death benefit from a life insurance policy is included as part of your estate. As such, it could be subject to estate taxes.
But when your life insurance policy is owned by an ILIT, that death benefit is not considered part of your estate. It can be paid to beneficiaries through the trust without the payment of either state or federal estate taxes.
Liquidity for heirs after your death
With an ILIT, the funds from the death benefit can be available to the beneficiaries very quickly after the insured’s death.
That can be especially useful for individuals who have much of their net worth tied up in assets that aren’t liquid, like a business or real estate. Their heirs may have to sell off real estate or part of the business to pay the estate taxes. However, with an ILIT, the proceeds are immediately available and can be used to pay any necessary estate taxes.
See: Setting Up a Trust for Your Child: Avoid These Mistakes
What are the drawbacks of creating an ILIT?
There are also some significant disadvantages.
ILITs are irrevocable
One rather obvious drawback is that an ILIT is irrevocable. Once you create it and name the beneficiaries, you no longer have any control over it. In practice, many trust grantors name close family members as the trustees of their ILITs.
The only way an ILIT can be dissolved is if the life insurance company cancels the insurance policy because of non-payment. The only other way to deal with an ILIT that no longer serves its original purpose is to sell it, possibly through a life settlement. Specialty brokers are used in this circumstance.
ILITs require thorough record-keeping
The IRS requires certain records to confirm that the ILIT, not the insured, owns the life insurance policy. The most common is something called a Crummey letter.
Here’s where it comes into play: The insured is allowed to put money into the ILIT bank account to pay the life insurance premiums. That transfer of money is considered a gift and is acceptable under the annual gift exclusion ($16,000 in 2022).
However, the insured must then send a Crummey letter notifying the beneficiaries of the trust that a gift has been made to the trust. The beneficiaries then have the right to withdraw the gifted money from the trust. Of course, if they did so, the trust wouldn’t have enough money to pay the life insurance policy’s premiums, and the policy would dissolve.
So beneficiaries need to understand the purpose of the ILIT — to provide benefits for them after the insured’s death. This means that ILITs will not be a good choice in circumstances with beneficiaries who would be likely to choose the instant gratification of a cash infusion over the long term benefit of the policy.
See: What are the Pros and Cons of Putting Rental Property Into a Trust?
Should you set up an ILIT?
ILITs are a useful tool for individuals and families with a high net worth. They help to reduce the estate tax burden and provide immediate liquidity to pay existing taxes. Keep in mind that the estate tax exemption may drop considerably in the coming years. Even if your net worth wouldn’t put you in estate tax territory today, it could in the future.
Remember that an ILIT is irrevocable and requires regular record-keeping. Creating an ILIT needs careful consideration with your estate planning attorney to ensure that you (and your loved ones) get the full benefit of it.
Schedule a confidential consultation with Siedentopf Law to determine whether an ILIT is an important element in your estate planning.
